This law says that a clause in a contract which sets out in advance the consequences of a breach of contract will be unenforceable if it is extravagant, exorbitant or unconscionable. It is one of the few exceptions in UK law to the principle of freedom of contract.

A test for this law was set out by Lord Dunedin in 1915 in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd. The test said that a clause was a penalty clause if the consequences are designed as a deterrent to discourage the defaulting party from committing the breach, and are not a ‘genuine pre-estimate’ of the loss that would be suffered by the aggrieved party as a result of the breach.

For the last 100 years this test has become entrenched, and UK lawyers (including me for the last 30 years) have gone around advising businesses to be very careful not to draft a clause which could be construed as a penalty clause and which could therefore be unenforceable.

On 4th November 2015 the UK Supreme Court (what used to be the House of Lords) gave its decisions in two completely different cases which it heard together. The result is that the law of penalties has been turned on its head. The Supreme Court set out a new test of whether a clause is a penalty clause, namely whether the agreed consequences of a breach impose a detriment to the contract breaker out of all proportion to the innocent party’s legitimate interest in the enforcement of the clause that has been breached. It doesn’t then seem to matter whether they are also designed to be a deterrent to discourage the defaulting party from committing the breach.

Read on for answers to some of the questions arising out of this case (including some drafting tips).

The cases:

The Supreme Court heard the appeals of two cases together. The facts were very different, but they both raised questions about the law of penalties.

In the first case (Cavendish Square Holding BV v El Makdessi) Mr Makdessi sold a controlling interest in a marketing and adverting business. The sale agreement contained restrictive covenants and said that if Mr Makdessi breached them he could be deprived of some deferred consideration and could be required under an option clause to transfer his remaining shares to the buyer as a low price (which excluded the value of goodwill).

In the second case (ParkingEye Ltd v Beavis) Mr Beavis drove into a car park. The car parking terms (which Mr Beavis could see before he parked and which formed a contract between him and the car park operator) said that drivers were only allowed to park for two hours, for free, and that after two hours a charge of £85 would be payable.

Mr Makdessi and Mr Beavis both argued that these clauses were unenforceable penalties.

The Supreme Court decided that the clauses were enforceable. It gave different reasons in each case.

Your questions answered:

·What is the law on penalties all about?

It says that a clause in a contract which sets out in advance the consequences of a breach of contract will be unenforceable if it is extravagant, exorbitant or unconscionable. This law is one of the few exceptions in UK law to the principle of freedom of contract - the clause will be unenforceable even if both parties have equally strong negotiating positions, have taken legal advice, and are perfectly happy with the clause.

(When I say ‘happy’, sometimes a business might be a bit devious and take the risk of accepting such a clause if it related to the consequences of their own breach of contract, punting on it being ruled out as unenforceable if it ever went to court.)

·Why would you want such a clause in the first place?

One of the things contracting parties are free to negotiate is a clause setting out what the consequences of a breach might be. The consequences might be that the defaulting party has to pay a pre-determined amount of damages (known as ‘liquidated damages’) or some other consequence such as having to transfer some rights or assets to the innocent party at a low value. It can provide more certainty to have this kind of clause so that everyone knows in advance what the consequences under the contract will be. Without such a clause one has to rely on complicated laws setting out what kinds of claims can be made for a breach of contract, and what kinds of exclusions and limitations can be inserted into a contract. And then someone has to prove what losses they have suffered which they can claim for as a result of a breach.

·Can you give me three examples of a possible unenforceable penalty clause?

oThe construction and engineering sectors often have liquidated damages clauses providing for compensation for delay in performance.

oShareholders agreements might provide that an employee shareholder must sell his shares for practically nothing if they are a ‘bad leaver’.

oA simple example is the amount of interest you can charge for a late payment.

·Has the law changed?

Yes and no. It depends how you look at it. Technically not, I suppose. The Supreme Court confirmed that the law against penalties continues to apply (although they did say ‘we rather doubt that the courts would have invented the rule today’). But we’ve been getting it wrong over the last 100 years by applying too rigid a test. The ‘old’ test was apparently wrong. The Supreme Court has given us a ‘new’ test.

·What was the ‘old’ test?

The ‘old’ test was set out by Lord Dunedin in 1915 in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd. The test said that a clause was a penalty clause if the consequences are designed as a deterrent to discourage the defaulting party from committing the breach, and are not a ‘genuine pre-estimate’ of the loss that would be suffered by the aggrieved party as a result of the breach.

·What is the ‘new’ test?

The Supreme Court set out a new test of whether a clause is a penalty clause, namely whether the agreed consequences of a breach impose a detriment to the contract breaker out of all proportion to the innocent party’s legitimate interest in the enforcement of the clause that has been breached. It doesn’t then matter whether they are also designed to be a deterrent to discourage the defaulting party from committing the breach.

·What has changed?

oThere is a big change of focus from having to show that there was a ‘genuine pre-estimate of loss’, to having to show that the aggrieved party had a legitimate interest in inserting the clause.

oIt no longer matters whether the clause is or was intended to be a deterrent to discourage a breach. If you have a legitimate interest in having a deterrent then you can have one so long as the deterrent is not ‘disproportionate’ (by which you can probably read ‘unfairly big’).

oThis all makes it easier to structure and draft commercial agreements in line with the bigger picture thinking behind them.

·How does the new test apply to these two cases which the Supreme Court ruled on?

oThe Supreme Court said that none of the clauses in these two cases would have infringed the new test.

oIn the Makdessi case the buyer had a legitimate interest in aligning the value of the goodwill which it was paying for against the restrictive covenants it was getting from Mr Makdessi; and to require Mr Makdessi to sell the buyer his remaining shares for a price which excluded any value for goodwill.

oIn the ParkingEye case, ParkingEye as the operator had a revenue model which to some extent depended on the ‘penalty’ charges (shouldn’t call them that!). And the owner of the car park (and ParkingEye as operator) had a legitimate interest to ensure the smooth operation of the car park so that cars didn’t overstay. The £85 ‘fine’ may have been a deterrent and intended to be a deterrent, but it was not disproportionate.

·Is the change retrospective?

Effectively, yes. If you have an existing contract which contains a liquidated damages clause or any other kind of clause setting out the consequences of a breach of contract, the ‘new’ test will apply to it.

If you thought it was a penalty clause and so you wouldn’t be able to enforce it or the other party wouldn’t be able to enforce it against you, you may want to think again!

·What type of clause does it apply to?

The Supreme Court made clear that the law of penalties only applied to ‘secondary obligations’ - clauses setting out methods of compensation resulting from a breach of a contract. It doesn’t apply to ‘primary obligations’, for example a clause saying ‘I will pay you this if you do that’.

·So can you structure contracts to get around this ‘secondary obligation’ thing?

Possibly. It’s all a bit confusing, as the distinctions between ‘primary’ and ‘secondary’ obligations are a bit blurry (see next question).

It may be worth trying to draft clauses so they look more like primary clauses. For example, in the ParkingEye case the clause was held to be a secondary obligation so it was capable of being a penalty (although the court ruled that based on the new test it actually wasn’t).

If the clause in the Parking Eye case had been reworded to say that a driver was allowed to park for a third hour but agreed to pay £85 if he did so, this would (probably) have turned it into a primary obligation which on the face of it couldn’t therefore have been questioned as a penalty. It would be a simple clause affecting price rather than a breach clause. This would then be enforceable (although unreasonable clauses can sometimes fall foul of other statutes. NB in the ParkingEye case one of the 7 judges dissented from the overall judgment because he said the clause fell foul of consumer rights laws.).

See some other suggestions below.

·Is the distinction between ‘primary’ and ‘secondary’ obligations clearcut?

Not really, in my view. Unless you think the following are clearcut:

oThe Supreme Court made a distinction between a clause which can be a primary obligation which is simply triggered by the breach, and a clause which is a secondary obligation because it provides for compensation for a breach. Whilst the Court of Appeal had ruled that the clauses in the Makdessi case were secondary obligations, the Supreme Court overruled this and held that they were actually worded as primary obligations even though they were both triggered by breaches of restrictive covenants. The options to buy Mr Makdessi’s remaining shares were triggered by the breaches. And the primary obligations to make further deferred payments of the purchase price were conditional on there being no breaches.

oAlso, the Supreme Court made clear that it is a question of substance rather than form. Essentially, there is a ‘taking the p*ss’ test. A court could decide that a clause worded as a primary clause was clearly only worded that way to get around the law on penalties. So, for example, if ParkingEye had a clause saying that the fee for a third hour was £1,000 rather than £85, I’m pretty sure a court would decide to say this was really a penalty clause.

·What if a clause looks like a penalty clause now with the benefit of hindsight, but didn’t at the time the contract was made?

You look at the context at the time the contract was made.

·Is the new law fairer?

Yes, in the sense that a court now has more discretion to decide on a fair balance between (1) allowing parties to negotiate freely whilst looking at the bigger picture, and (2) preventing a stronger party from bullying the other.

·Is the law now much clearer?

Yes and no. (I’m a lawyer…).

oWhy no? On the face of it the use of the expressions ‘out of all proportion’ and ‘legitimate interest’ in the new test will give courts in future plenty of scope to apply whatever decision they actually personally think is fair. Parties who are suing each other may not have a clear idea what a judge will decide unless and until a case goes all the way to court. So litigators may be happy.

oWhy yes? I suspect that where parties with equal bargaining power have finally negotiated a clause which clearly they have both agreed is proportionate (fair) on one party to protect the other party’s legitimate interests, a court will be reluctant to question their judgment.

·Are the parties’ relative negotiating positions relevant?

It looks like it. Under the old test it didn’t matter whether they were or not – the test was simply whether the damages were a genuine pre-estimate of loss for the aggrieved party. But the law was largely designed to protect parties in weaker positions from being bullied - it is unconscionable to take advantage of someone’s weaker position – so judges will no doubt factor this in when deciding whether stated consequences are ‘out of all proportion’ to the claimant’s ‘legitimate interests’.

·Do you have any drafting tips?

oSet out the reason for the clause. If it is not obvious, explain what legitimate interests you are looking to protect and why you think the clause represents a reasonable and proportionate protection of those interests.

oIf you are in any doubt as to whether the consequences of a breach might be too disproportionate if the breach is only a small breach out of a possible range of breaches, then set it out in different steps, ie cover various possible permutations in your drafting.

oConsider using legal ‘tools’ such as put and call options, and adjustable deferred consideration clauses, to turn your provisions into ‘primary obligations’ which can’t be challenged as penalty clauses.

·Do you have any predictions as to how the law might develop further?

There are already statutory laws (such as the Unfair Contract Terms Act) which apply ‘reasonableness’ tests to certain contract clauses, such as those attempting to limit or exclude liability, and which take into account the parties’ respective bargaining positions. There is also a trend towards courts trying to allow parties freedom to negotiate whilst not allowing a more powerful party to bully a weaker one. I suspect that the law on penalties will develop until one day a general test of this kind is applied to all contracts. As part of this trend, I suspect that the importance of the distinction between ‘primary obligations’ and secondary obligations/breach clauses will become less and less important as courts in future create new case law which tries to make sense of the various laws.